Bigger Is Not Always Bad

Raghuram G. Rajan is the Eric J. Gleacher Distinguished Service professor of finance at the University of Chicago’s Booth School of Business. He is the author of "Fault Lines."

December 7, 2010

There is a real question in the United States about whether large banks should be broken up, given that some European countries have gotten into trouble because of banks that are too big to save.

A blanket ban on institutional size would merely eliminate good as well as bad large banks.

A poorly managed large financial institution can pose an enormous risk for any economy even while it has significant ability to lobby for protection (recall Fannie and Freddie, for example). The key question, though, is whether large banks inevitably become excessively risky. The answer is unclear.

Consider the case against large banks. Once they get beyond a certain size, large banks are unlikely to be allowed to fail. Smaller banks can undertake senseless mergers or build complicated organizations with the sole objective of getting too big or too connected to fail. And creditors, knowing that the larger banks are protected, then start paying less attention to the risks these banks are taking. The net result: lower economic efficiency and greater risk. Moreover, large banks can lobby for favorable regulation (they are probably as formidable as large energy companies in this respect), allowing them to subvert the system, which relies on competition.

Finally, mismanaged large banks can take countries down. Ireland guaranteed its banks’ liabilities, and the markets now fear that the country itself will not be able to repay creditors. Both UBS and Royal Bank of Scotland have been a source of concern for their respective countries, Switzerland and the United Kingdom, in large part because of the size of their assets relative to the size of the economy. Of course, the United States is much bigger relative to the size of its largest banks than any of these countries, but it would suffer if a couple of big banks go seriously off-track.

However, before assuming that large banks are necessarily inefficient and risky, we have to consider other routes through which firms can become large. Clearly, firms can be both efficient and large if there are significant economies of scale or scope. However, studies show that economies of scale are exhausted once a bank becomes moderately large. Indeed, there could be diseconomies of scale as banks become increasingly hard to manage — Citigroup being a case in point. Nevertheless, even if economics of scale are minor, large firms may be more efficient and profitable — simply because it is the successful firms that grow faster in a competitive environment.

In addition, large firms have the resources to attract better talent and to build better organizational structures. Not all big banks have done this -- Citigroup has been on the verge of meltdown about once every 10 years over the last three decades; banks like JP Morgan have provided a conservative and stable core to the system.

Besides, small and medium-sized banks in the U.S. have not shown better judgment than the riskiest large ones — many face severe problems today from large exposures to real estate. While a poorly managed $2 trillion bank creates immense problems for the system, the problems could be even greater with 100 banks of $20 billion in size, each of which has taken similar risks.

What is important is not just size per se but the concentration and correlation of risk in the system as well as the size of exposures relative to capital.

So what should we do? Instead of imposing a blanket ban on institutions growing beyond a certain size, and thus eliminating good, as well as bad large banks, regulators should increase the costs of becoming large so that only the most efficient survive. To start with, mergers of large banks should rarely be allowed, and large banks that seem to have a propensity for getting into trouble should be encouraged to break up. Such powers are already possessed by entities like the Federal Trade Commission.

Apart from being supervised more closely (which regulators already do), big banks should be required to hold more capital and to issue substantial quantities of bonds that will suffer losses (or convert to equity) if they ever receive any government assistance. With signs of impending trouble, large banks should be barred from making dividend payments and their senior employees should have to take salary and bonus payments beyond a certain level in the form of new shares.

We should also make troubled large banks easier to close. Requiring that banks file “living wills” (statements about how they would be resolved if they got into trouble) and that they discuss the wills regularly with regulators could reduce complexity. We should seek agreements between countries on how to resolve banks with operations across countries.

Finally, we should reduce deposit insurance, an anachronistic subsidy for banks. Deposit insurance may still make sense for small banks that are poorly diversified and subject to bank runs. But for large well-diversified banks, deposit insurance merely contributes to excess. We will have to bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Phasing out deposit insurance as domestic deposits grow beyond a certain size would be far more effective in reducing unnecessary size, and far easier to implement, than blanket size limits.